Ever since it became clear that the pace of the economic recovery was falling short of expectations, two competing narratives have vied to dominate our politics. Movement conservatives argue that the weight of a government that “spends too much, taxes too much, and borrows too much” is suffocating the private sector and that new laws and regulations have throttled investment and job creation by creating uncertainty about the costs of doing business. Keynesian liberals, meanwhile, counter that the problem is the collapse of demand and that the government’s failure to offer a large enough stimulus is consigning us to a rate of growth not easy to distinguish from stagnation.
What if they’re both wrong? That’s the claim of Amir Sufi, a finance professor at the University of Chicago’s Booth School of Business. The data tell a compelling story, he argues: “The main factor responsible for both the severity of the recession and the subsequent weakness of the economic recovery is the deplorable weakness of the U.S. household balance sheet,” which is, Sufi shows, “in worse condition than at any other point in history since the Great Depression.”
Because Sufi’s argument makes so much intuitive sense, I started digging into the data for myself. And the information I found supports his thesis.
For instance, according to reports issues quarterly by the Federal Reserve Board of New York, household debt rose from $4.6 trillion in 1999 to $12.5 trillion in early 2008. After three years of painful deleveraging (mainly through home foreclosures and reductions in credit card balances), it still stands at $11.5 trillion—roughly where it was at the beginning of 2007.
To understand the burden this imposes on households, let’s look at a key measure: the ratio of household debt to disposable income. Between 1965 and 1984, the ratio remained steady at 64 percent. Between 1985 and 2000, it rose virtually without interruption to 97 percent. And then, it shot into the stratosphere, peaking at 133 percent in 2007. Four years later, according to the Federal Reserve Bank of San Francisco it has come down only modestly: Household debt still stands at 118 percent of disposable income.
The official figures confirm the widespread belief that mortgage debt is the core of the problem. In 1999, mortgages accounted for 69 percent of household debt. Today, it’s 74 percent, of a total that has more than doubled. Worse, the conventional wisdom that households used their homes as piggy banks during the boom turns out to be correct. During most of the 1990s, equity extracted from homes through home equity loans amounted to about 1 percent of disposable income. By the peak of the bubble in 2006, that figure had risen to a rate of $800 billion per year—a stunning 9 percent of disposable income. And we know that all that extracted equity was spent, because the personal savings rate collapsed to near-zero during that period. When housing prices collapsed, households were left with a mountain of debt, and little equity with which to offset it. Not surprisingly, equity withdrawals also collapsed, to -1 percent, by early 2008.
What’s more, consider that it has been 42 months since the peak of the business cycle, and 24 months since the trough. At a comparable point in the aftermath of the two prior recessions (1990-1991 and 2001), real household net worth per person had fully recovered. But, today, real per capita household net worth stands more than 15 percent below its peak. Similarly, at this point in the prior two recoveries, real personal consumption expenditures per person had reached and exceeded their pre-recession peak. According to a report just out from the San Francisco Fed, consumption per person today is still 1.6 percent below its 2007 peak and is growing very slowly.
SO THE DATA seem to support Professor Sufi’s thesis, and, if Robert Hall’s Presidential Address to the 2011 meeting of the American Economics Association—which focuses on the housing collapse and the impact of high household commitments to debt service, as well as rigidities in financial instruments and policies—is any indication, academic economists are beginning to pay attention. (Hall cites Sufi’s work.) But what does this mean, in practice, for public policy?
In recent remarks, President Obama has acknowledged that his administration’s housing policy hasn’t been adequate to the challenge. If Sufi is right, that has been the Achilles Heel of the administration’s entire economic program. If the core of the problem is excessive household debt, and three-quarters of that is in mortgages that millions of homeowners can’t service, then the solution requires writing down mortgage debt to a far greater extent than policymakers have yet attempted.
It’s understandable that, at the height of the crisis, with the entire global financial system teetering on the brink, the administration was reluctant to contemplate steps that would have furthered impaired the capital position of major institutions. But that time has long passed. Meanwhile, the policies of the Federal Reserve Board have allowed these institutions first to recapitalize and then to profit handsomely from a benign interest rate environment.
It’s time, then, to reexamine our housing policy from the ground up. If employers won’t hire until consumer demand increases, and if demand won’t increase until household balance sheets recover, then policymakers should focus on accelerating that recovery. Here’s a back-of-the envelope calculation: If we need to return the household debt burden to where it stood before the bubble, we can either wait another four or even five years (which is what it would take at the current rate without additional intervention), or we can speed it up by allocating the losses of principal that lenders need to accept and remove from their books. Moving the household debt to disposable income ratio from 118 percent to the pre-bubble 100 percent implies a total debt reduction of roughly $1.5 trillion.
I wonder what would happen if the financial wizards whose innovations helped crater the world economy turned their attention to devising a plan for reducing household debt to healthier levels without destabilizing systemically important lenders. One thing, though, is clear: Nothing of the sort will happen unless President Obama and Treasury Secretary Geithner set aside their incomprehensible passivity and fealty to the financial community’s cramped vision and get to work on the problem.
William Galston is a senior fellow at the Brookings Institution and a contributing editor for The New Republic.